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Your Guide to GAAP

Here's why we need generally accepted accounting principles, and what they entail.

Though accounting professionals frequently have the option to use different methods in the course of their jobs, as a general rule, public companies, governments, and nonprofit organizations are all required to adhere to a set of accounting standards. These standards are known as generally accepted accounting principles, or GAAP.

Under GAAP, companies and entities must follow specific procedures in their financial reporting and disclose certain financial information in the statements they put out. Having a uniform set of standards helps to ensure that everyone follows the same rules and, in the case of public companies, that investors are put in the best position to make informed decisions.

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Basic principles of accounting

Developed by the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB), GAAP creates a set of universal standards for public companies and entities to follow. Companies that put out financial statements are required to adhere to GAAP. Furthermore, when those statements are audited, those tasked with reviewing them must ensure that they've been prepared in accordance with GAAP.

But it's not just public companies that need to follow GAAP. Today, all 50 state governments adhere to GAAP when preparing their financial reports. And while most states don't mandate that local governments follow GAAP, an estimated 70% of local governments do so anyway.

A common set of principles

The goal of GAAP is to get all public companies and entities on the same page, so to speak, with regard to reporting practices. Some of the primary areas that fall under GAAP include:

Disclosure, or the information shared on financial statements

Recognition, or how revenues, expenses, assets, and liabilities are acknowledged and accounted for

Measurement, or how profits and losses are calculated and recorded

Presentation, or how information is shared with the public

Why do we need GAAP?

GAAP serves the important purpose of creating a standard for financial reporting. GAAP helps to ensure a certain level of consistency, which is particularly important for investors. If an investor is choosing between two companies, each of which has its own unique method of accounting, then that investor won't be able to make a reliable comparison. On the other hand, if both companies are required to disclose the same information and follow the same standards for recognizing and measuring revenue, then investors have can reasonably expect to make meaningful comparisons between them. Furthermore, GAAP helps hold government and nonprofit entities to a certain level of transparency, which better serves the public.

Limitations of GAAP and the use of non-GAAP financial metrics

GAAP is valuable, but it isn't perfect, and its standards don't always fit perfectly with the way every business works. You'll therefore often find companies report both GAAP and non-GAAP (adjusted) results, especially with earnings.

The various adjustments that companies make to their GAAP results to come up with non-GAAP numbers are too numerous to list here, but some of the more common ones include:

Excluding the impact under GAAP of items such as interest expense, income taxes, depreciation, and amortization.

Taking out the negative impact of stock-based compensation on GAAP earnings.

Excluding the financial impact of irregular events, such as mergers and acquisitions, restructuring activities, settlement payments, and severance packages to laid-off employees.

Accounting differently for items that are required to be included in GAAP numbers but that don't involve an actual outlay of cash.

There's nothing that requires companies to use any particular methodology in releasing non-GAAP measures of financial performance. However, a company does have to provide a roadmap that tells investors exactly what factors went into producing the adjusted numbers and how the company reconciles its non-GAAP and GAAP results. Moreover, certain non-GAAP metrics have become commonplace in particular industries, and so competitive pressure pushes companies in those industries to release non-GAAP results using the same specific methodology in order to make comparisons easier.

That said, even GAAP itself is merely a set of standards, and while those standards serve an important function, they can't guarantee that the companies or entities that follow them are putting out correct or honest information. Though GAAP creates a system of checks and balances within the financial reporting realm, companies and entities can still get away with taking certain liberties. Without GAAP, however, there'd be much less accountability with regard to public disclosure, so the fact that these standards are in place is a very good thing indeed.

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